People often say that as a result of the crash millions of people lost their homes before they could pay their mortgage off. However, it also seems that the housing crash was directly a result of millions of people defaulting on their mortgage payments. Are both true? Is it just a roundabout way of saying that irresponsible bankers offered mortgages to clients when they should have known they would default? Does this claim have anything to do with changing interest rates, unemployment or the depreciation of housing prices?
In: Economics
This is a long and fairly complex story, below is a simplified version…
Taking a step back: When you take out a mortgage the bank doesn’t hold onto it. It’s not like in “it’s a wonderful life” where the Savings and Loan (btw – that’s another financial crisis to look up!) holds onto the mortgage and using incoming revenue to write new mortgages. Instead they bank promptly sells it to a bigger bank – if you ever take out a mortgage you’ll get a letter about 6-8 weeks later telling you it’s now owned by a different company, with instructions on any changes to where you send your payments. Your bank gets all their profits from the loan immediately and now has $$$ on hand to issue another loan. So their incentive is to write as many loans as possible.
The bigger bank might then sell a giant package of loans to an even bigger bank, and so on. Same deal. Eventually you run out of big enough banks. So in the late 90’s to early 00’s the financial sector came up with “mortgage backed securities” – giant packages of loans that they sold to pension funds (the biggest banks on the planet) or to the stock market. This kept money coming in to the bigger banks to keep buying loans from the smaller banks so they could keep writing new loans.
/ this is long, bear with me.
These offered really good returns for the risk profile so it was easy to sell them.
Problem was – they were lying about the risks. Along the way all these super high risk loans that should never have been written were being packaged up with ultra safe loans so the whole package got a really good risk rating. Then they’d slice and dice the packages again to put more and more high risk loans in – gaming the system to get AAA ratings for products that should have been C/D rated. The super high ratings meant that things like pension funds were under a lot of pressure to buy them because the risk profile pensions operate under means a significant portion of the fund has to go to the very highest rated assets and aside from Treasury Bonds almost nothing comes close to AAA, and treasury bonds give a really bad return on investment- which they can get away with because they’re a safe asset.
They were able to keep this up for a while because the house market was constantly rising so any loans that defaulted were easily sold for more than the loan value and everyone who was owed money got paid.
Then it got to the point that so many loans were defaulting that they couldn’t keep it hidden anymore and cracks started to show. House prices stalled out, and started falling. Now there wasn’t enough money from the sales to pay everyone so all these giant financial funds started to look closely at what they’d been sold and realized they were sitting on garbage loans that were going to default.
So they stopped buying loans.
So the big banks stopped getting money to buy loans from smaller banks.
So the smaller banks stopped getting money to write new loans.
So the access to credit to fuel the housing market boom vanished.
So house prices fell.
This meant anyone who’d bought a house and defaulted was basically out their life savings because their deposit was nuked. So they stopped spending money in the rest of the economy.
It also meant all these giant financial institutions at the top didn’t have any money to write loans for other types of business venture, which tanked a large portion of the economy. This resulted in even more people losing their jobs and having to sell their homes, which tanked the housing market further, and wiped out a huge portion of their life savings. This cycled a few times for about a year hitting various sectors of the economy and putting loads of people out of work and caused a lot of loan defaults so a lot of people lost their homes.
Looping back to the initial question you have on defaulting – one thing that helped fuel all this were “ARM” mortgages – these offer a short term at a very low interest rate and then the rates increase substantially. These were used to write mortgages to people who should never have been given loans – the low initial payments allowed them to be able to service the loan for a few years, but they would never be able to make payments once the rates started adjusting – but when the banks stopped writing loans as easily these people couldn’t refinance so were fucked and lost their homes.
There were other similar high risk products going on too – loans that were interest only for a few years, so the borrowers weren’t even clearing their loan balance, loans with “balloon payments” where large lump sums are due in certain years to enable overall lower interest rates, and a lot of “refinance” loans given to people who were facing financial difficulties so tapped into their home equity- borrowing against an inflated home value. All these groups ended up in a lot of trouble.
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